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    Committee on Energy and Natural Resources

    Committee Chairman: Jeff Bingaman

    Washington, DC • April 3, 2008


    The Price of Oil: A Reflection of the World

    By James Burkhard, Managing Director, Cambridge Energy Research Associates

    It is an honor to address this Committee on the relationship between oil prices and the

    influence of noncommercial institutional investors, sometimes referred to as market speculators.

    Trading in futures markets establishes the reference price for nearly all crude oil sold in the world.

    Crude oil futures trading activity on the New York Mercantile Exchangethe largest in the

    1worldis currently about 350 percent higher than in 2002. Noncommercial investors have

    contributed to this increase. Growth in trading activity is coincident with a rise in oil prices from

    $26 per barrel in 2002 to more than $100 in early 2008. The concurrence of these two trends has

    raised the question about the level of influence that noncommercial investors have in oil price


     What has been driving oil prices upward? It is primarily the fundamentals of demand and

    supply, geopolitical risks and rising industry costs. The decline in the value of the dollar has also

    played a role, particularly in the past six months. But with noncommercial investors playing a

    bigger role, the direction of a given price trend can be accentuated. And since the credit crisis first

    erupted last summer, energy and other commodities have become caught up in the turbulence of

    the global economy.

    1The figure of 350 percent represents the increase in open interest in NYMEX crude oil contracts, which is a proxy for levels of trading activity. Open interest is defined by the US Commodity Futures Trading Commission as “the total number of futures contracts long or short in a delivery month or market that has been entered into and not yet liquidated by an offsetting transaction or fulfilled by delivery.”


Noncommercial Investors

    The US Commodity Futures Trading Commission defines noncommercial or speculative

    investors as those who are not physically exposed to the commodity but trade with the objective

    of achieving profits through the successful anticipation of price movements. This group of

    market participants includes more than just short-term speculative traders. It represents a broad

    spectrum of investors with different time frames and motivations such as mangers of pension

    funds, university endowments and other institutional investors. These investors increasingly view

    commodities and oil in particular as an asset class. They allocate investment capital based upon a

    view of the world’s need for oil and other commodities. For example, the California Public Employees Retirement System (CalPERS), the largest public pension fund in the United States,

    recently increased the amount it could invest in an asset class that includes commodities. This

    move is part of a “new strategy to provide a hedge against inflation while diversifying investments,

    2thus mitigating losses during equity market downturns.”

    Noncommercial investors are an essential part of a futures market. In the 1860s Chicago grain

    traders developed the first futures contract: an agreement to buy or sell a commodity at a future

    date. Farmers were able to offload price risk to speculative traders. In exchange for providing

    price certainty to the farmer, the trader had the opportunity to turn a profitor a lossfrom

    future price changes. This allocation of risk remains the foundation of today’s futures markets.

    Noncommercial investors can also provide another attribute of a well functioning futures

    market: liquidity. Liquidity refers to how quickly a counterparty can be found for a transaction.

    The current turbulence in credit markets illustrates the dangers that materialize when trading in a

    market becomes illiquid. Uncertainty and fear come to the fore, which exacerbates market turmoil.

    Oil futures markets are among the most liquid in the worldand have remained so despite the upheaval in credit markets.

    In a sufficiently liquid market, the number and value of trades is too large for speculators to

    unilaterally create and sustain a price trend, either up or down. The growing role of non-

    2 CalPERS February 19, 2008 press release.


commercial investors can accentuate a given price trend, but the primary reasons for rising oil

    prices in recent years are rooted in the fundamentals of demand and supply, geopolitical risks, and

    rising industry costs. The decline in the value of the dollar has also played a role, particularly since

    the credit crisis first erupted last summer, when energy and other commodities became caught up

    in the upheaval in the global economy. To be sure, the balance between oil demand and supply is

    integral to oil price formation and will remain so. But “new fundamentals”—new cost structures

    and global financial dynamicsare behind the momentum that pushed oil prices to record highs

    around $110 a barrel, ahead of the previous inflation-adjusted high of $103.59 set in April 1980.

New Cost Structures

    In 2004 the price of oil (in nominal terms) averaged above $40 for the first time ever. This

    was sparked by extraordinary demand growth that reflected strong global economic expansion

    and a temporary surge in the use of oil to generate power in China. Further demand growth in

    2005 reduced spare oil production capacity to just 1 million barrels per day (mbd)compared

    with 4 to 6 mbd in the 1990s. Amid the whittling away of spare capacity, political change and

    security worries in several major oil exporting countries fueled anxiety about the adequacy of oil

    supplies. With so little spare capacity, such fears drove oil prices higher.

    As oil prices rose, so did demand for the people and equipment needed to find, develop and

    produce oil. But nearly 20 years of low oil prices and industry consolidation meant “a missing

    generation”—a generation that skipped entering the petroleum industry. As a result, major

    shortages of equipment and personnel dramatically raised the cost of developing an oil field

    whether in the Gulf of Mexico, West Africa or the Middle East. CERA and IHS have developed a

    series of indices to measure changes in costsort of a Consumer Price Index for the energy

    industry. Costs to build power plants and oil refineries have surged higher. But the one most

    relevant to our discussion today is the latest IHS/CERA Upstream Capital Cost Index. This index

    shows a doubling of oil field costs over the last three years. In other words, companies have to

    budget twice as much today as they did three years ago. Adding to the cost pressure are

    increasingly heavy fiscal terms on oil investments in the form of higher taxes and greater state

    participation in oil projects. The net result is that much higher oil prices are needed to support


development of new supplies. Some projects that in the past needed oil prices of $20 or $30 in

    order to move forward now need price levels that are double that amountor even higher.

    It can take ten years or more to find, develop and begin production from a new oil field,

    particularly if it is large and complex. Long lead times and the severe upturn in costs have led to

    one of the most significant changes in the oil market: a steep increase in long term oil price

    expectations. For nearly two decades, until 2004, expectations for long-term oil prices hovered

    around $18 to $25 per barrel. Since 2004 the price of a futures contract to buy or sell crude oil

    five years out has risen steadily. It topped $100 per barrel this year. Five years is considered long-

    term from an oil market perspective as opposed to the longer times that can be required to

    develop a new oil field. The sustained breakout of oil prices from a relatively narrow historical

    range along with global financial dynamics has fostered greater interest in oil among financial


Global Financial Dynamics

    The oil price has long reflected major trends in the economy and geopolitics. Rising inflation,

    a rush to invest in commodities and worrisome tension between the United States and Iran drove

    oil above $100 per barrel in real terms in 1980. In 1998 the price of oil collapsed largely because

    of the fallout from the Asian financial crisis. Today, two major trends that are reflected in the

    price of oil are the decline of the dollar and the rising economic clout of many regions outside the

    United States.

Oil and the Dollar: The New Gold

    The effect of a declining dollar on the price of oil first became prominent in early 2005. The

    dollar had fallen about 35 percent relative to the euro since 2002. OPEC generally imports more

    from Europe than the United States, so a weak dollar damages terms of trade from OPEC’s

    perspective. The falling dollar contributed to the lifting of OPEC’s implicit oil price objective,

    which altered market expectations about price and the balance between demand and supply. The

    price of oil was nearing $50 per barrela very high price at the time.


    In the past half year lower interest rates and anticipation of further cuts in interest rates

    pushed the dollar lower. Amid great turbulence in credit and other financial markets, the nature of

    the weak dollar’s influence on the oil market changed. Oil has become the new gold”—a

    financial asset in which investors seek refuge as inflation rises and the dollar weakens. This may

    seem counterintuitive at a time of weak oil demand in the United States, but today’s dynamics in

    the marketplace reveal oil’s increasingly cosmopolitan nature. The price of oil reflects not only

    demand and supply, but broader macroeconomic and geopolitical changes such as the growing

    influence of Asia, the Middle East, Russia and the Caspian countries.

    Strong economic growth outside the United States has not only supported growing oil

    demand but also propelled rising demand and prices for many commodities. In addition to energy,

    food prices are surging around the world. According to the International Monetary Fund. global

    prices for cerealswheat, rice, corn (maize), and barleyincreased 82 percent from 2000 to 2007. More than half of this increase has been in the past two years. Recent data from China show

    food prices pushing overall inflation to 8.7 percentthe highest level in more than a decade.

    A key element of the “oil as the new gold” story is the expectation that demand for oil will continue to grow, and thus be able to hold its value despite a weak dollar and rising inflation. To a

    degree, an expectation of a strong oil price is a bet on the future of China and India. The United

    States is the world’s largest oil consumer, but 75 percent of global demand is outside the United

    States. For example, since the beginning of 2007 eight of the ten largest oil markets in the world

    (excluding the United States and Saudi Arabia, whose currency is pegged to the dollar) have seen

    significant currency appreciation ranging from 9 percent (India) to 19 percent (Brazil). When a

    currency appreciates against the dollar, it diminishes the impact of an increase in the dollar price

    of oil in that market. Also, regulated prices of gasoline and diesel in some key markets means that

    consumers are not exposed to the full increase in the global market price of those products. This

    places pressure on government and company budgets, but if a given country enjoys strong

    economic growth it can withstand, at least for a time, rising oil prices.


    If economic and oil demand growth remain vibrant in large markets around the world and the

    dollar continues to weaken, then financial dynamics could continue to drive oil prices higher. But


oil’s role as a financial hedge does not mean that its price will rise continuously. Prior to the

    ascent in recent years, both gold and oil prices had been mired in long-term price slump. In the

    late 1990s, $100 oilor even $80 oil seemed preposterous. Today, $20 oil seems quaint.

    The political and manpower difficulties currently constraining oil supply growth will not

    disappear overnight. The desire for higher living standards in China, India, the Middle East,

    Russia and elsewhere will remain as strong as it was in Europe, Japan and the United States in the

    post World War II years. Higher living standards mean longer life expectancy, lower infant

    mortalityand higher energy consumption.

    But just when the future seems preordained in the oil market, the unexpected can unfold. It

    did in the decade following 1998, just as it had several times since 1970. This year will be a stiff

    test for the new oil price era that dawned on the world several years ago. Economic growth is the

    single most important determinant of oil demand growthand the course of the global economy

    in 2008 is fraught with worries.

    Financial innovation and the globalization of securities helped to lubricate the wheels of the

    global economy during an extraordinary expansion, but it also created risks that were notand

    still are notfully understood. The US subprime mortgage meltdown is the most current example

    of misunderstood risk, but is it the last?

    Oil prices can remain high during an economic downturn. In the early 1980s, one of the

    weakest periods of economic growth since the depression of the 1930s, oil prices were at very

    high levels for several years. But eventually, the economy and demand catch up: the 1986 oil price

    collapse was due to a multiyear decline in oil demand.

    This year, just as economic worries began to mount, oil prices touched a new high of about

    $110 per barrel. Although oil prices are only one factor affecting the global economy, they are a

    significant one. Because the world economy took $70 per barrel in stride does not mean that it

    would easily absorb $100. If prices hover in the $90-$100 plus range for six months or more, then

    it would be increasingly difficult to argue that high oil prices do not have a significant impact on

    economic growth. Moreover, given the growing use of corn-based ethanol, oil prices are now

    connected to food prices, which are rising. And the increase in food prices is a major source of


inflation in many emerging markets around the world. Oil prices are fluctuating in line with the

    latest economic signalsup and down. This will continue until a clearer view of economic growth materializes. But one factor is clear. The price of oil will reflect major swings in the value of the

    dollarboth up and down.

    James Burkhard, Managing Director of CERA’s Global Oil Group, leads the team of CERA

    experts that analyze and assess oil markets and strategies. His team also develops and maintains

    detailed short- and long-term outlooks for global oil supply and demand. Mr. Burkhard's

    expertise covers geopolitics, world economic conditions, and global oil demand and supply

    trends. Mr. Burkhard was the project director of Dawn of a New Age: Global Energy Scenarios

    for Strategic Decision MakingThe Energy Future to 2030, CERA’s comprehensive study

    encompassing the oil, gas, electricity and renewable energy sectors. He is also the coauthor of

    CERA’s respected World Oil Watch, which analyzes short- to medium-term developments in the

    oil market. In addition to leading CERA’s oil research, Mr. Burkhard served on the US National

    Petroleum Council (NPC) committee that provided recommendations on US oil and gas policy to

    the US Secretary of Energy. He led the team that conducted the energy demand analysis and

    developed the demand-oriented recommendations that were published in the 2007 NPC report

    Facing the Hard Truths About Energy. Mr. Burkhard holds a BA from Hamline University and

    an MS from the School of Foreign Service at Georgetown University.


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